Fortnightly - MACRShttp://www.fortnightly.com/tags/macrs
enRegulated Tax Equity Financehttp://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance
<div class="field field-name-field-import-deck field-type-text-long field-label-inline clearfix"><div class="field-label">Deck:&nbsp;</div><div class="field-items"><div class="field-item even"><p>Distribution utilities could become an important source of renewable funding.</p>
</div></div></div><div class="field field-name-field-import-byline field-type-text-long field-label-inline clearfix"><div class="field-label">Byline:&nbsp;</div><div class="field-items"><div class="field-item even"><p>Ralph Loomis</p>
</div></div></div><div class="field field-name-field-import-bio field-type-text-long field-label-inline clearfix"><div class="field-label">Author Bio:&nbsp;</div><div class="field-items"><div class="field-item even"><p><b>Ralph Loomis</b> is managing director of Global Renewable Solutions (GRS) LLC, which provides business and financial advisory services for renewable energy development. This article draws upon work the author performed for the Bipartisan Policy Center.</p>
</div></div></div><div class="field field-name-field-import-volume field-type-node-reference field-label-inline clearfix"><div class="field-label">Magazine Volume:&nbsp;</div><div class="field-items"><div class="field-item even">Fortnightly Magazine - March 2013</div></div></div><div class="field field-name-field-import-image field-type-image field-label-above"><div class="field-label">Image:&nbsp;</div><div class="field-items"><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1303-BIZ-fig1.jpg" width="2067" height="1312" alt="Figure 1 - Utility Renewable Investment Proposition" title="Figure 1 - Utility Renewable Investment Proposition" /></div></div></div><div class="field field-name-body field-type-text-with-summary field-label-hidden"><div class="field-items"><div class="field-item even"><p>With the expiration of the Section 1603 cash grant program, tax equity likely will re-emerge as the investment vehicle of choice for renewable finance. But the tax equity market is tightening.</p>
<p>European banks are exiting the U.S. project finance market due to the financial crisis in Europe, and other established tax equity providers simply lack sufficient tax capacity to pick up the slack. Many within the renewable development community are looking for alternative structures, and alternative sources of funding. Domestic technology companies, large industrials, and utilities are frequently cited as promising new sources of tax equity supply, and a number of these companies have actually availed themselves of the opportunity. Google, for example, has invested almost $850 million in clean energy, mostly in the form of tax equity investments in projects such as the Shepherds Flat wind farm in Oregon. Several utility holding companies have likewise made tax equity investments in distributed solar through unregulated affiliates.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="1. US Clean Energy – White Paper, Bloomberg New Energy Finance, 21 Nov. 2011">1</a></sup></b></p>
<p>Yet by and large, corporate participation in renewable tax equity finance has been limited. There are a number of plausible explanations. First and foremost, the business interest of many companies is far removed from renewable development, and even farther removed from renewable finance. Even those that have adopted aggressive corporate sustainability objectives find it easier to buy renewable energy than to finance it. According to the most recent CREX survey, which measures corporate renewable energy procurement, renewable energy accounted for 12.1 percent of total consumption of surveyed companies in 2010, up from 8.2 percent in 2009. But only a limited amount of this energy was purchased from projects that were directly financed by the company—1 percent in 2009 and 0.6 percent in 2010. Tax equity investment might appeal to some these companies in time, but today project finance is considered relatively time-intensive and costly when compared to other forms of renewable energy procurement.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="2. Global Corporate Renewable Index (CREX) June 2011, BNEF">2</a></sup></b></p>
<p>Conversely, for companies whose business interest is more closely aligned with renewable development, particularly those in the energy and utility sectors, tax equity investment is seen as contrary to their financial interests. Many of these companies are themselves engaged in owning and operating energy assets. In the electric sector, independent power producers, both foreign and domestic, are actively engaged in so-called utility-scale renewable development projects. They don’t see themselves as being in the business of financing competitors or competing technologies. Except in an unusual case, they wouldn’t seem to be likely sources of tax equity investment.</p>
<p>There is one group of companies, however, that would seemingly benefit from the tax equity investment opportunity. In the 30-plus jurisdictions that have adopted renewable portfolio standards, local electric distribution companies are the initial point of regulation. These companies are required by statute to ensure that a designated percentage of the load they deliver is derived from renewable resources. Penalties generally are imposed when they fail to comply. Assuming they have the necessary tax capacity, they would seem to have a clear business interest in assuring renewable development on favorable terms to meet the statutory requirement.</p>
<p>Ironically, however, many of these companies are statutorily prohibited from owning or operating any generation, renewable or otherwise. Pursuant to state restructuring laws, they are pure wires companies, dedicated to the reliable delivery of the energy produced by others. They stand at the intersection of past efforts to restructure the industry, to make it more competitive, and current efforts to repower the industry with renewable resources. Affording these companies the opportunity to participate as passive tax equity investors in renewable assets could advance both agendas, as well as the interests of customers.</p>
<h4>How We Got Here</h4>
<p>Developing a tax equity strategy that works for both distribution utilities and regulators requires a clear sense of the industry’s evolution to its situation today.</p>
<p>Historically, electric utilities in the United States were structured as vertically integrated, regulated monopolies—they generated, transmitted and distributed electricity in exclusive franchise service territories, subject to both federal and state regulation. The scheme worked reasonably well for almost 80 years, given the steadily declining cost of electricity.</p>
<p>In the mid-1980s however, the utility industry came under fire for cost overruns arising from the nuclear build-out of the 1970 and ’80s. Policymakers at both federal and state levels began to reconsider the traditional regulatory model. In 1992 Congress passed a comprehensive Energy Policy Act that among other things set the stage for non-discriminatory open access to the transmission grid, and competitive wholesale markets.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="3. The Energy Policy Act of 1992, 102nd Congress, H.R. 776 ENR, 1992.">3</a></sup></b> Subsequently, under the Federal Energy Regulatory Commission’s landmark Orders 888 and 889, utilities were obliged to turn over control of their transmission systems to regional independent system operators, such as PJM and ISO New England, and participate in regional competitive wholesale power markets.</p>
<p>State policymakers followed suit. First in California in 1997, and then in the Northeast, Mid-Atlantic and some Midwestern states, industry restructuring schemes were enacted that required utilities to surrender their traditional monopolies.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="4. For an excellent discussion of the economic theory behind industry restructuring, see Paul Joskow, “Restructuring, Competition and Regulatory Reform in the US Electric Sector,” Journal of Economic Policy, Summer 1997.">4</a></sup></b> Many were required to disaggregate and in some cases divest their generation assets, and some were even required to open their distribution systems to competitive retail suppliers. As a consequence, in many parts of the country traditional state-regulated distribution utilities became wires-only companies. Such companies are generally out of the business of building, owning, and operating power-generating assets, renewable or otherwise. In some cases they no longer even sell electricity to their customers for profit; customers increasingly are served by competitive alternative or retail energy suppliers, or by a so-called default service, regulated to pass through market prices.</p>
<p>The spread of retail industry restructuring came to a precipitous halt in 2002, however, with the implosion of the California electricity market and the ensuing Enron scandal. California and a number of other states suspended their restructuring initiatives, and many other states simply changed the subject. Today, while two-thirds of the country is served by regional transmission organizations and competitive wholesale markets, only 17 states, representing 40 percent of overall U.S. retail load, have restructured retail electricity markets.</p>
<p>It’s probably fair to say that the final chapter on industry restructuring has yet to be written. At the wholesale level, there’s demonstrable evidence that open-access transmission and competitive wholesale energy and capacity markets have improved the operating performance of existing generation, and that electricity prices have become more responsive to market forces.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="5. See generally, Electricity, U.S. Energy Information Administration.">5</a></sup></b> At the retail level, competitive volumes and accounts continue to increase in retail competition states, with nearly 9 million residential customers and more than 1.8 million business and government customers exercising electricity choice in the 17 competitive jurisdictions.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="6. Compete, Customer Choice in Electricity Markets: From Novel to Normal, Phillip R. O’Connor, PhD, November 2010.">6</a></sup></b> Moreover, there’s a growing conviction that retail choice effectively complements demand response, energy efficiency, and the integration of renewable resources along with the emergence of the smart grid.</p>
<p>In one critical respect, however, competitive markets have yet to meet policymakers’ expectations. Reflecting the nuclear experience, one of the principle objectives of industry restructuring was to put the risk of new generation development on corporate shareholders, rather than captive utility customers. While there was a flurry of merchant investment in the immediate aftermath of state restructuring, it came to an abrupt halt when natural gas prices spiked in 2003. Subsequent efforts to promote new generation, including the creation of multilateral capacity markets at the wholesale level, have yet to spur significant development, despite an aging coal and nuclear generation fleet. The prospect of making large, long-term infrastructure investments to serve a volatile and uncertain energy market is seen as too risky, absent both economic incentives and long-term contractual assurances. Utility customers remain the linchpin to successful generation development.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="7. Ironically, we’ve rediscovered one of the primary drivers for the regulated monopoly form of utility regulation.">7</a></sup></b></p>
<p>Unfortunately, this is particularly true in the case of emerging forms of renewable generation, with their untested technologies and higher perceived risk.</p>
<h4>Renewable Incentives</h4>
<p>Policymakers at both the federal and state level have long been proponents of clean energy and renewable energy development. As early as 1978, Congress enacted the Public Utility Regulatory Policies Act (PURPA) to promote innovative alternative energy development. And as early as 1982, Iowa adopted the first renewable portfolio standard (RPS) to promote wind development.</p>
<p>Currently, the federal government oversees a wide variety of initiatives to promote the supply of clean energy technologies. Congress has authorized grant and loan guarantee programs administered by the Department of Energy. Congress likewise has enacted a wide variety of tax incentives, including production tax credits (PTC), investment tax credits (ITC), MACRS (modified accelerated cost recovery system) and even bonus depreciation of up to 100 percent to advance renewable deployment. And until recently, Congress authorized the Treasury Department to oversee the very successful Section 1603 cash grant program to buttress the financing of renewable projects.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="8. See NREL, Preliminary Analysis of the Jobs and Economic Impacts of Renewable Energy Projects Supported by the §1603 Treasury Grant Program, April 2012.">8</a></sup></b></p>
<p>State governments likewise support incentives for renewable development, mostly through utility sponsored subsidy programs. More importantly, however, state policymakers have also enacted RPS requirements to promote renewable demand. As a practical matter, however, even generous supply incentives won’t succeed in the absence of assured long-term demand.</p>
<p>Twenty nine states and District of Columbia have adopted renewable standards that require local distribution utilities to purchase increasing percentages of renewables for the load they serve. The standards themselves vary widely from state to state, not only in the percentage of load and timetable, but in the types of technologies that qualify.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/5" title="9. See U.S. DOE, Database of State Incentives for Renewables and Efficiency.">9</a></sup></b> Importantly, 20 of these states previously restructured their utility industries, and 14 have required that local distribution companies divest themselves of all generation assets, or at least segregate those assets in a separate competitive generation affiliate.</p>
<p>In most cases, compliance is assured through so-called renewable energy credits (REC), which evidence renewable energy purchases and can be auctioned and traded but ultimately must be surrendered to state regulators. A distribution utility that doesn’t have the required RECs might have to make alternative compliance payments. Generally speaking, the cost of RECs can be passed through to customers; whether the cost of alternative compliance payments can be passed through is less certain. Moreover, local distribution companies are frequently urged to acquire these RECs by entering into long-term purchase power agreements (PPA). These long-term agreements assure developers that they will receive a price certain for both the output and RECs of their projects, and are essential to project financing.</p>
<p>To date, these seemingly complementary federal and state policies have succeeded in promoting the deployment of substantial renewable resources.<b><sup><a a="" argue="" at="" failure="" federal="" from="" href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" leadership="" learning="" march="" of="" others="" public="" result="" that="" the="" they="" title="10. There is a rich ongoing debate about just how complementary these policies are. Some argue that state RPS enactments demonstrate the continuing virtue of federalism, where state governments can serve as policy laboratories. (See Thomas J. Sloan, " utilities="">10</a></sup></b> Since 2000, renewable electricity installations in the United States—excluding hydro—have more than tripled, totaling 59 GW of installed capacity in 2010. Renewables have grown at a compounded annual growth rate of about 14 percent over the period.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="11. 2010 Renewable Energy Data Book, U.S. Department of Energy.">11</a></sup></b> And there can be little doubt that the incentives themselves are critical to that deployment. Wind development in particular correlates closely with congressional authorization and reauthorization of the PTC.</p>
<p>But there also have been unintended or at least unappreciated consequences to the current federal-state incentive scheme. First and foremost, there’s the cost. Even as the unit costs of renewable technologies come down, the cost of financing their deployment is stubbornly high. While internal rates of return vary by deal and deal structure, a recent base-case analysis by Bloomberg New Energy Finance found that developers can achieve returns of 6 to 19 percent for wind, and 13 to 36 percent for solar projects. But the tax equity investors who finance the projects can then see investment returns as high as 50 percent on top of developer returns.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="12. Bloomberg New Energy Finance, U.S. Clean Energy White Paper at 24.">12</a></sup></b> Of course not all investors achieve such returns, but certainly developing and financing renewable projects can be very lucrative, given the interplay between federal and state incentives.</p>
<p>Second, in many cases utility balance sheets are effectively underwriting these projects, even though the utility itself doesn’t own the renewable asset. A creditworthy off-taker is an essential prerequisite to renewable finance, and utilities are often the preferred creditworthy off-taker. Yet utility shareholders, often institutional investors and pension funds, see no return for the increased risk utilities bear in purchasing expensive, long-term power in an uncertain power market.</p>
<p>Third, and perhaps most concerning, customers continue to bear the cost and risk of new generation development. When utilities are called upon to enter into long-term contracts with renewable developers to insure financing of yet-to-be-built projects, utility customers are the ones ultimately obligated. The industry restructuring goal of shifting development risk to investors hasn’t been met.</p>
<p>This isn’t to say that federal tax incentives or renewable portfolio standards should be abandoned. To the contrary, renewable portfolio standards have proven effective at ensuring renewable demand, and tax equity finance—while complicated—has promoted both renewable supply and new entry by independent generation developers. But the cost has been high. As federal subsidies shrink and the total cost of RPS compliance mounts, the industry might need to look not only for new sources of capital, but for less expensive sources of capital. Specifically, what role could local distribution utilities play in financing these projects consistent with both restructuring and renewable policy agendas?</p>
<h4>Assessing Utilities’ Tax Capacity </h4>
<p>It’s essential to take a realistic look at the actual tax capacity of the affected utility sector.</p>
<p>In a recent white paper, Bloomberg New Energy Finance reviewed 15 major investor-owned utility holding companies, and concluded that both their strategic interest in renewables and their most recent tax obligations, on the order of hundreds of millions of dollars, could incline them to make tax equity investments.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="13. Id. at 8-9.">13</a></sup></b> That observation is borne out by the fact that a number of these companies, including PG&amp;E, Duke, and Integrys, already have made tax equity investments in solar generation.</p>
<p>But it’s critically important to recognize that these tax equity investments have been made in distributed as opposed to utility-scale projects, and in markets where the companies didn’t otherwise compete or operate. PG&amp;E’s $100 million investment in SunRun, for example, was made by an unregulated investment affiliate for residential solar development in a five-state area largely outside the PG&amp;E service territory.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="14. See PG&amp;E Press Release, June 21, 2010.">14</a></sup></b> And Duke and Integrys have likewise entered into a joint venture with Smart Energy that’s focused on distributed rather than utility-scale commercial and industrial projects; their most recent project was for a school in New Jersey.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="15. Duke, Integrys, Smart Energy Press Release, Jan. 18, 2012.">15</a></sup></b> As noted earlier, it’s highly unlikely that similar tax equity investments would be made in the face of a competing business interest. As one corporate development officer at a major holding company recently mused, “We’re not a bank; we’re in the business of owning and operating assets, not financing them for others!”</p>
<p>Moreover, federal and state regulators have adopted aggressive affiliate conduct rules that preclude cross-subsidies between and among holding company affiliates. Regulators are particularly concerned that distribution customers shouldn’t be called upon to underwrite the business fortunes of a utility’s other affiliates—particularly competitive affiliates—or that customers of one state don’t end up underwriting the service of customers in another state. Conversely, holding companies are disinclined to engage in cross-subsidization between regulated and competitive affiliates for fear that state regulators will thereafter deny rate relief for the regulated company because of the business success of its parent or affiliates. It’s therefore highly unlikely that a parent company would or could make a tax equity investment to aid a retail distribution affiliate in meeting its RPS obligations.</p>
<p>As a consequence, in considering whether utility distribution companies would be a likely source of new tax equity investment, the tax capacity of the regulated company itself must be distinguished from that of its affiliates or corporate parent. Unfortunately, that isn’t always easy to do. Many utility holding companies report only on a consolidated basis. And a number of holding companies, particularly in competitive states, are foreign owned. Nonetheless, a survey of recent 10K filings reveals that in 2011 a total of 58 utility distribution companies in RPS states separately reported federal taxes totaling $7.3 billion on their income statements. Their effective tax rates varied greatly, from 45.8 percent to a negative<i> </i>33.6 percent. Importantly, however, 35 of the 58 companies reported zero or negative current taxes for the year. In reality, they paid no federal taxes in 2011.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="16. See Appendix A.">16</a></sup></b> The result is similar for utility distribution companies that no longer own generation assets. For 2011, a total of 30 such companies filed separate 10Ks reporting federal taxes of $3.3 billion on their income statements, with effective tax rates varying between 45.8 percent and 26.5 percent. But again, 19 of these companies reported negative current taxes.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="17. See Appendix B.">17</a></sup></b></p>
<p>Clearly, companies with an actual tax liability in 2011 would appear to be candidates for some level of renewable tax equity investment. Assuming they can obtain favorable regulatory treatment, tax equity investment could afford them an opportunity to both meet their RPS compliance obligations and earn an attractive return.</p>
<p>For companies with no current tax liability, however, the question is much more complicated. In most cases, negative current taxes arise from bonus depreciation provisions separate and apart from renewable tax incentives. Since 2003, Congress has enacted a series of temporary bonus depreciation provisions, ostensibly to promote domestic investment.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="18. See “Quick Facts: Bonus Depreciation and 100% Expensing,” Tax Policy Center.">18</a></sup></b> Distribution utilities, as capital intensive entities, have been quick to avail themselves of these deductions. Their appetite for additional renewable incentives will depend not only on future business results and future regulatory requirements, but on whether the current bonus depreciation provisions will be extended, and to what extent they can carry forward past tax losses to offset future income.</p>
<p><span class="s3">If bonus depreciation isn’t extended, their tax capacity could increase significantly. It’s therefore very difficult to make blanket statements about the overall tax capacity of the utility distribution sector. Investment decisions will invariably have to be made on a case-by-case basis, and will inevitably have to reflect a wide variety of considerations. Clearly, it would be a mistake to conclude that either the utility sector as a whole, or the distribution sector in particular, are a vast, untapped source of tax equity for renewable development.</span></p>
<p>It wouldn’t be a mistake, however, to recognize that many of these utilities could view renewable incentives and renewable investments more favorably, both from a RPS compliance and tax planning perspective, if state regulators afforded them an incentive to invest—particularly one that would benefit both utility shareholders and customers, and reduce the overall cost of RPS compliance. And as noted by Bloomberg, even a small number of new corporate entrants could dramatically improve tax equity availability, and close the gap between demand and supply.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/6" title="19. Bloomberg New Energy Finance, U.S. Clean Energy White Paper at 10.">19</a></sup></b></p>
<h4>Aligning Risk and Reward</h4>
<p>Tapping into the investment potential of distribution utilities will require both progressive utility leadership and progressive state regulation. Distribution utilities subject to RPS compliance requirements, even those that have exited the generation sector, must come to see renewable investment as good business, not inconsistent with their mission of developing a smarter and more resilient distribution system. Regulators, in turn, must come to see these investments not only as a means of advancing in state renewable development and reducing the overall cost of RPS compliance to customers, but also as a means of addressing many of the unintended consequences arising from the interplay between federal and state renewable incentives.</p>
<p>Utility tax equity investment could take a variety of forms, including so-called “flip partnerships,” sale-leasebacks, or inverted leases. In restructured jurisdictions, however, it would most likely take the form of a flip partnership to avoid restrictions on utility ownership. In a flip partnership, the project developer would develop, construct, and operate the facility as general partner. The utility would provide equity capital and take the facility output as a passive limited partner. Importantly, the partnership would legally own the renewable asset unless and until the developer exercised a call right. As permitted by IRS guidelines, the utility as passive investor would get almost all of the project’s tax and economic benefits for a prescribed flip period (<i>e.g.,</i> six to 10 years), after which a greater portion of the benefits would revert to the developer.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/7" title="20. See Rev. Proc. 2007-65.">20</a></sup></b></p>
<p>The opportunity to invest could be made available in any jurisdiction that has adopted an RPS, regardless of the status of industry restructuring. In traditional jurisdictions, the utility would have the option of owning and operating the facility as a rate-base asset or investing in a development partnership with a renewable developer. While utilities in traditional jurisdictions are more likely to opt for direct ownership, particularly for so-called utility-scale renewable projects, there could be individual cases where they see advantage in letting someone else develop and operate the facility. This is particularly true for distributed solar facilities, such as those owned by small commercial or residential customers.</p>
<p>In restructured jurisdictions, where wires-only utilities don’t have the option of owning and operating renewables as rate-base assets,<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/7" title="21. But see the Green Communities Act of 2008, which affords local distribution companies in Massachusetts the option of owning up to 10 MW of renewable generation as a rate-base asset in an otherwise restructured jurisdiction. Interestingly, both National Grid and WMECO have been quick to avail themselves of the opportunity, thus proving once again that utilities respond to affirmative monetary incentives.">21</a></sup></b> tax equity investment would act as an affirmative incentive for utilities to promote local renewable development. Not surprisingly, many distribution companies currently see renewables as outside their business interest. For these utilities, RPS compliance is nothing more than an unavoidable regulatory expense to be passed on to retail customers. An affirmative investment incentive, however, would recast renewable development as a preferred way to meet compliance obligations.</p>
<p>The rate treatment of these tax equity investments could take a variety of forms. First, even in restructured jurisdictions the tax equity investment could be included in utility rate base as an “intangible utility asset,” earning a return similar to that of other more tangible utility assets. This was the approach proposed by San Diego Gas &amp; Electric in July 2010, with respect to the 309-MW Rim Rock wind project in Montana.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/7" title="22. Application of San Diego Gas &amp; Electric to Amend Renewable Energy Power Purchase Agreement with NaturEner Rim Rock Energy LLC, and for Authority to Make a Tax Equity Investment in the Project, A1007017, Filed July 15, 2010.">22</a></sup></b> In essence, SDG&amp;E had previously entered into an approved long-term PPA with Rim Rock for output and renewable energy credits. When the developer’s subsequent efforts to secure financing failed, and the project was in danger of being abandoned, SDG&amp;E sought permission to amend the PPA and finance the facility itself, at a cost of $600 million or 79.99 percent of required equity. SDG&amp;E proposed that the deal be structured as a flip partnership, with SDG&amp;E as a passive investment partner and the developer as the general partner. SDG&amp;E contended that the flip structure would actually benefit customers by reducing the ultimate cost of financing and making the project less risky than if SDG&amp;E owned and operated the facility itself. Although the filing was initially met with great skepticism by independent power producers and ratepayer advocates, in July 2011 the California Public Utilities Commission ultimately approved a scaled down investment that preserved the tax equity structure.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/7" title="23. See https://financere.nrel.gov/finance/content/rim-rock-wind-agreement-reached">23</a></sup></b></p>
<p>While the outcome in the SDG&amp;E filing confirmed that tax equity deals can be done in regulated space, the administrative process itself was quite burdensome, and expensive. It might not be suitable for anything other than the largest utility-scale renewable projects, and even then it’s unlikely that most renewable developers would willingly subject themselves to such a lengthy and expensive process. It certainly wouldn’t be suitable for smaller projects, including particularly distributed solar projects.</p>
<p>Alternatively, regulators should consider establishing a utility renewable investment pilot program. Rather than treating each investment as a separate adjudicatory event, overall renewable investment criteria and a true-up process could be established by rulemaking. Utilities would then be free to invest in accordance with the criteria, subject to a periodic administrative process that would ensure that both utility shareholders and utility customers shared in the benefits of that investment under a pre-established formula.</p>
<p>Consider a hypothetical 5-MW solar project in Massachusetts to be completed in 2012. Assume that a developer and the utility enter into a 10-year flip partnership agreement for a facility with a total cost of $17.8 million. Under the agreement, the developer agrees to develop and construct the facility, and manage it once it becomes operational. The utility agrees to provide equity financing for 52 percent of project costs, with the remaining 48 percent financed as debt at 6.25 percent. The utility also agrees to purchase the output of the facility at 10 cents/kWh, and the renewable energy credits for $285/MWh, for 10 years. Project proceeds, including federal tax incentives and the value of the RECs, go almost exclusively to the utility investor during the initial flip period; after year 10, however, they go 70 percent to the developer, and 30 percent to the utility. Assume also that the developer elects to exercise its call right in year 11, and purchases the project. The investment potential of the project under such a structure is quite substantial; even under the most conservative assumptions, the utility as investor would stand to earn an IRR of almost 24 percent on its investment over the period.<b><sup><a href="http://www.fortnightly.com/fortnightly/2013/03/regulated-tax-equity-finance/page/0/7" title="24. See Appendix C.">24</a></sup></b></p>
<p>The intriguing question, however, is how that return could then be apportioned between utility shareholders and utility customers, and the effect that that apportionment would have on the overall cost of RPS compliance. Using the investment modeling results, Figure 1 compares two compliance scenarios—the more typical “Utility as Purchaser” scheme, where the utility assures RPS compliance by purchasing the output and RECs of a renewable project financed by a traditional tax equity investor, and the proposed “Utility as Investor” scenario where the utility stands in the shoes of the tax equity investor. Even assuming a simple split-the-savings approach, both the utility and its customers benefit under the investment scenario.</p>
<h4>Fostering Development</h4>
<p>A regulatory scheme that encourages distribution utilities to link their RPS compliance obligation with tax equity investment could provide a number of benefits.</p>
<p>First, it opens the door to a new group of tax equity investors—investors who have both a strategic interest in renewable development and the potential tax capacity to avail themselves of federal incentives. While the actual investment potential of the sector as a whole is unknown, distribution utilities collectively and individually could be an important new source of financing for local renewable development.</p>
<p>Second, it would address many of the unintended consequences of the current federal-state renewable incentive scheme—specifically, by lowering the overall cost of renewable financing; by compensating utility shareholders for the increased risk imposed by long-term off-take agreements; and by allowing customers to share in renewable tax incentives as compensation for the risk they inevitably bear as the ultimate backstop for renewable development.</p>
<p><span class="s3">Third, it has the potential to greatly benefit renewable developers, who in future could be afforded a one-stop shop for both off-take agreements and finance. It arguably would also streamline the interconnection process, since the local distribution company as investor would have a financial interest in speedy interconnection.</span></p>
<p>Finally, in restructured jurisdictions it preserves and arguably fosters restructuring and one of its key goals—adequate development of new, independent generating capacity.</p>
<p> </p>
<h4>Endnotes:</h4>
<p>1. US Clean Energy – White Paper, Bloomberg New Energy Finance, 21 Nov. 2011</p>
<p>2. Global Corporate Renewable Index (CREX) June 2011, BNEF</p>
<p>3. The Energy Policy Act of 1992, 102nd Congress, H.R. 776 ENR, 1992.</p>
<p>4. For an excellent discussion of the economic theory behind industry restructuring, see Paul Joskow, “Restructuring, Competition and Regulatory Reform in the US Electric Sector,” <i>Journal of Economic Policy</i>, Summer 1997.</p>
<p>5. See generally, <a href="http://205.254.135.7/Electricity" target="_blank">Electricity</a>, U.S. Energy Information Administration.</p>
<p>6. <i>Compete, Customer Choice in Electricity Markets: From Novel to Normal</i>, Phillip R. O’Connor, PhD, November 2010.</p>
<p>7. Ironically, we’ve rediscovered one of the primary drivers for the regulated monopoly form of utility regulation.</p>
<p>8. See<i> </i>NREL, Preliminary Analysis of the Jobs and Economic Impacts of Renewable Energy Projects Supported by the §1603 Treasury Grant Program, April 2012.</p>
<p>9. See U.S. DOE, <a href="http://http://www.dsireusa.org" target="_blank"><i>Database of State Incentives for Renewables and Efficiency</i></a>.</p>
<p>10. There is a rich ongoing debate about just how complementary these policies are. Some argue that state RPS enactments demonstrate the continuing virtue of federalism, where state governments can serve as policy laboratories. (See Thomas J. Sloan, "<a href="https://www.fortnightly.com/fortnightly/2013/03/learning-states">Learning from the States</a>," <i>Public Utilities Fortnightly</i>, March 2013, p.8.”) Others argue that they result from a failure of leadership at the federal level.</p>
<p>11. <i>2010 Renewable Energy Data Book</i>, U.S. Department of Energy.</p>
<p>12. Bloomberg New Energy Finance, U.S. Clean Energy White Paper at 24.</p>
<p>13. <i>Id</i>. at 8-9.</p>
<p>14. See <a href="http://www.pgecorp.com/news/press_releases/Release_Archive2010/100621press_release.shtml" target="_blank">PG&amp;E Press Release</a>, June 21, 2010.</p>
<p>15. Duke, Integrys, <a href="http://www.reuters.com/article/2012/01/18/idUS155501+18-Jan-2012+PRN20120118Archive2010/100621press_release.shtml" target="_blank">Smart Energy Press Release</a>, Jan. 18, 2012.</p>
<p>16. See <a href="http://www.fortnightly.com/regulated-tax-equity-appx-a">Appendix A</a>.</p>
<p>17. See <a href="http://www.fortnightly.com/regulated-tax-equity-appx-b">Appendix B</a>.</p>
<p>18. See “<a href="http://www.taxpolicycenter.org/taxtopics/Bonus-Depreciation-and-100-Percent-Expensing.cfm" target="_blank">Quick Facts: Bonus Depreciation and 100% Expensing</a>,” Tax Policy Center.</p>
<p>19. Bloomberg New Energy Finance, U.S. Clean Energy White Paper at 10.</p>
<p>20. See Rev. Proc. 2007-65.</p>
<p>21. But see the Green Communities Act of 2008, which affords local distribution companies in Massachusetts the option of owning up to 10 MW of renewable generation as a rate-base asset in an otherwise restructured jurisdiction. Interestingly, both National Grid and WMECO have been quick to avail themselves of the opportunity, thus proving once again that utilities respond to affirmative monetary incentives.</p>
<p>22. Application of San Diego Gas &amp; Electric to Amend Renewable Energy Power Purchase Agreement with NaturEner Rim Rock Energy LLC, and for Authority to Make a Tax Equity Investment in the Project, A1007017, Filed July 15, 2010.</p>
<p>23. See <a href="https://financere.nrel.gov/finance/content/rim-rock-wind-agreement-reached" target="_blank">https://financere.nrel.gov/finance/content/rim-rock-wind-agreement-reached</a></p>
<p>24. See <a href="http://www.fortnightly.com/regulated-tax-equity-appx-c">Appendix C</a>.</p>
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<a href="/tags/finance">Finance</a><span class="pur_comma">, </span><a href="/tags/renewable">Renewable</a><span class="pur_comma">, </span><a href="/tags/funding">funding</a><span class="pur_comma">, </span><a href="/tags/section-1603">Section 1603</a><span class="pur_comma">, </span><a href="/tags/project-finance">Project finance</a><span class="pur_comma">, </span><a href="/tags/shepherds-flat">Shepherds Flat</a><span class="pur_comma">, </span><a href="/tags/tax-equity">tax equity</a><span class="pur_comma">, </span><a href="/tags/crex">CREX</a><span class="pur_comma">, </span><a href="/tags/renewable-portfolio-standards">Renewable portfolio standards</a><span class="pur_comma">, </span><a href="/tags/rps">RPS</a><span class="pur_comma">, </span><a href="/tags/grs">GRS</a><span class="pur_comma">, </span><a href="/tags/monopolies">monopolies</a><span class="pur_comma">, </span><a href="/tags/energy-policy-act">Energy Policy Act</a><span class="pur_comma">, </span><a href="/tags/pjm">PJM</a><span class="pur_comma">, </span><a href="/tags/iso-new-england">ISO New England</a><span class="pur_comma">, </span><a href="/tags/wires-only">wires-only</a><span class="pur_comma">, </span><a href="/tags/california">California</a><span class="pur_comma">, </span><a href="/tags/enron">Enron</a><span class="pur_comma">, </span><a href="/tags/regional-transmission-organization">regional transmission organization</a><span class="pur_comma">, </span><a href="/tags/rto">RTO</a><span class="pur_comma">, </span><a href="/tags/open-access-0">open-access</a><span class="pur_comma">, </span><a href="/tags/retail-choice">retail choice</a><span class="pur_comma">, </span><a href="/tags/infrastructure">Infrastructure</a><span class="pur_comma">, </span><a href="/tags/public-utility-regulatory-policies-act">Public Utility Regulatory Policies Act</a><span class="pur_comma">, </span><a href="/tags/purpa">PURPA</a><span class="pur_comma">, </span><a href="/tags/iowa">Iowa</a><span class="pur_comma">, </span><a href="/tags/wind">Wind</a><span class="pur_comma">, </span><a href="/tags/production-tax-credits">production tax credits</a><span class="pur_comma">, </span><a href="/tags/ptc">PTC</a><span class="pur_comma">, </span><a href="/tags/investment-tax-credits">Investment tax credits</a><span class="pur_comma">, </span><a href="/tags/itc">ITC</a><span class="pur_comma">, </span><a href="/tags/macrs">MACRS</a><span class="pur_comma">, </span><a href="/tags/modified-accelerated-cost-recovery-system">modified accelerated cost recovery system</a><span class="pur_comma">, </span><a href="/tags/rec">REC</a><span class="pur_comma">, </span><a href="/tags/purchase-power-agreement">purchase power agreement</a><span class="pur_comma">, </span><a href="/tags/ppa">PPA</a><span class="pur_comma">, </span><a href="/tags/bloomberg">Bloomberg</a><span class="pur_comma">, </span><a href="/tags/pge">PG&amp;E</a><span class="pur_comma">, </span><a href="/tags/duke">Duke</a><span class="pur_comma">, </span><a href="/tags/integrys">Integrys</a><span class="pur_comma">, </span><a href="/tags/sunrun">Sunrun</a><span class="pur_comma">, </span><a href="/tags/cross-subsidy">cross-subsidy</a><span class="pur_comma">, </span><a href="/tags/san-diego">San Diego</a><span class="pur_comma">, </span><a href="/tags/sdge">SDG&amp;E</a><span class="pur_comma">, </span><a href="/tags/rim-rock">Rim Rock</a> </div>
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